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Transcript of CHAPTER 11 The International Monetary System. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies,...
CHAPTER 11
The International Monetary System
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Learning Objectives What are the differences between fixed and
floating exchange rates?
What kind of business strategies do firms use to guard against the volatility of exchange rates?
Current event-Currency crisis in Brazil & Role of IMF
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Chapter Focus
Explain how the international monetary system works. Review the system’s evolution.
The gold standard. Bretton Woods - 1944.
Reasons for the Bretton Woods failure. The present system.
Float versus fixed. Implications for business.
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The International Monetary System
The institutional arrangements that countries adopt to govern exchange rates.
Dollar, Euro, Yen and Pound “float” against each other. Floating exchange rate:
Foreign exchange market determines the relative value of a currency.
Some countries use other institutional arrangements to fix their currency’s value.
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Some countries use: Pegged exchange rate.
Value of currency is fixed relative to a reference currency.
Dirty float.Hold currency value within some range of a reference currency.
Fixed exchange rate.Set of currencies are fixed against each other at some mutually agreed upon exchange rate.
Require somedegree ofgovernmentintervention.
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The Gold Standard
Roots inmercantile
trade.Inconvenient to ship
gold, changed topaper - redeemed
for gold.
Seeking a“balance of trade”
equilibrium.
Pegging currenciesto gold and
guaranteeingconvertibility.
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Balance of Trade Equilibrium
Trade Surplus
GoldIncreased
money supply = price
inflation.
Decreased money supply
= price decline.
As prices decline, exportsincrease and trade goes
into equilibrium.
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Bretton Woods
1944:44 countries meet in New Hampshire.Fixed exchange rates deemed desirable.
Agree to peg currencies to US dollar that is convertible to gold at $35/oz.
Promise not to devalue currency for trade purposes and will defend currencies.Created:
World Bank International Monetary Fund.
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The Role of the IMFWant to avoid problems following WWI.
Discipline:Fixed rate imposes discipline:
Need to maintain rate stops competitive devaluations.Imposes monetary discipline, curtailing inflation.
Flexibility:Lending facility:
Lend foreign currencies to countries having balance-of-payments problems.
Adjustable parities:Allow countries to devalue currencies more than 10% if B of P was in “fundamental disequilibrium’.
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The Role of the World Bank
International Bank for Reconstruction and Development (IBRD).Rebuild Europe’s war-torn economies.
Overshadowed by the Marshall Plan.
Turns to ‘development’.Lending money to Third World nations.
Agriculture.Education.Population control.Urban development.
IBRD raises money in bond market and lends at ‘market rate’.
International Development Agency raises money through subscriptions
and lends to very poor countries.
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10
15
20
US Germany Japan Britain France
USGermanyJapanBritainFrance
Largest Contributors
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Collapse of the Fixed Exchange Rate System
Collapsed in 1973.Pressure to devalue dollar led to collapse.
President Johnson financed both the Great Society and Vietnam by printing money.
High inflation.High spending on imports.
President Nixon took dollar off gold standard and kept 10% import tax.Countries agreed to revalue their currencies against the dollar.
Bretton Woods fails when key currency (dollar) is under speculative attack.
Now have a managed-float system.
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The Floating Exchange Rate Regime
Jamaica Agreement - 1967Floating rates acceptable.Gold abandoned as reserve asset.IMF quotas increased.
IMF continues role of helping countries cope with macroeconomic and exchange rate problems.
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Exchange Rates Since 1973
More volatile: Oil crisis -1971. Loss of confidence in the dollar - 1977-78. Oil crisis - 1979. Unexpected rise in the dollar - 1980-85. Rapid fall of the dollar - 1985-87 and 1993-
95. Partial collapse of European Monetary
System - 1992. Asian currency crisis - 1997.
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90
100
110
120
130
140
150
160
US Dollar Movements
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Fixed versus Floating Exchange Rates
Floating: Monetary policy
autonomy. Restores control to
government. Trade balance
adjustments. Adjust currency to
correct trade imbalances.
Fixed: Monetary discipline. Speculation.
Limits speculators. Uncertainty.
Predictable rate movements.
Trade balance adjustments.
Argue no linkage between exchange rates and trade.
Linkage between savings and investment.
Which system is better?Evidence is unclear.
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IMF Members’ Exchange Rate Policies, 2000
27%
15%
6%24%
4%
20%4%
Free Float
Managed Float
Adjustable Peg
Fixed PegArrangementCurrency BoardArrangementNo separate Tender
Other
Figure 10.2
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Target Zones: The European Monetary System in Retrospect
An exchange rate system based on target zones involving a group of countries trying to keep their currencies within a predetermined ‘zone’, of other currencies in the group.
Created in 1979: Create stability by reducing volatility and
inflation. Control inflation by imposing monetary
discipline. Coordinate exchange rates between EU and non-
EU currencies such as the dollar and yen. Created the European currency unit (Ecu) and
the exchange rate mechanism (ERM) to achieve objectives.
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Crisis Management by the IMF
Role has expanded to meet crisis. Currency crisis. Banking crisis. Foreign debt crisis.
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Incidence of Currency Crises1975-1997
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
1975 79 83 87 91 95
Developed
Developing
Number of Currency Crises per Country
Figure 10.3a
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Mexican Currency Crises of 1995
Peso pegged to U.S. dollar. Mexican producer prices rise by 45%
without corresponding exchange rate adjustment.
Investments continued ($64B between 1990 -1994.
Speculators began selling pesos and government lacked foreign currency reserves to defend it.
IMF stepped in.
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Peso Movements
0
20
40
60
80
100
120
140
160
Index
= 1
00
Mexico
94 95
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Asian Crisis
1997:Investment boom.Excess capacity.Debt.Expanding imports.
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Impact of the Asian Financial Crisis on US Imports
0 10 20 30 40 50 60
Apparel
TV & VCR
Appliances
199819971996
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Devalued Currency
0
20
40
60
80
100
120
Index
= 1
00
Thailand
I ndonesia
S. Korea
1997 1998
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Evaluating the IMF’s Policy Prescriptions
Inappropriate policies:“One size fits all’.Moral hazard:
People behave recklessly when they know they will be saved if things go wrong.
Foreign lending banks could fail.Foreign lending banks have paid price for rash lending.
Lack of Accountability.IMF has grown too powerful.
Unclear as to theappropriatenessof IMF actions.
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Implications for Business
Currency management. Business strategy.
Forward exchange market (months not years ahead).
Strategic flexibility. Corporate-government relations.
